Krones Group Annual Report 2017

Dear shareholders and friends of Krones,

2017 was a successful year overall for Krones. Despite a market and competitive environment that are not altogether easy, business was good and our numbers were on target. Krones also made important decisions in the reporting period to ensure our continued strong performance.

Drinktec 2017 was a huge success for Krones

Of course, the drinktec trade fair was the absolute highlight of 2017. Drinktec is the beverage and liquid food industry’s equivalent of the World Economic Summit and takes place only once every four years. The fair was a resounding success for Krones. Attendee feedback on our innovations was very positive and our customers’ interest in placing orders was more than satisfactory. Some of the innovations we took to the fair are described on pages 41 to 45 of this report. One topic that dominated drinktec like no other was digitalisation. That shows that there is a general sense of excitement about it across the industry and confirms that we are on the right track.

Digitalisation is an enormous opportunity for growth

The digitalisation of beverage plants holds enormous potential for Krones. As a full-service supplier, we are able to connect all processes and data along the entire value chain. We intend to increase the efficiency of our customers’ lines considerably by intelligently analysing and linking data with human and machine knowledge. In so doing, we are creating additional value for our customers. Fortunately for us, that is by no means new territory for Krones. We are already supporting our customers with IT products and services and will continue to place particular emphasis on the digital intelligence of all new and evolving developments.

Business development satisfactory overall

Although sales prices provided no support once again in 2017, we were able to offset rising costs for personnel and purchased goods and services to such an extent that we achieved our growth and earnings targets for the year. Revenue increased 8.8% to €3.69 billion. Earnings before taxes (EBT) improved by 8.9% to €259 million. And at 7.0%, our EBT margin was as planned. Our core segment, Bottling and Packaging Equipment, developed slightly better than expected while our Process Technology segment did not meet its earnings targets. We intend to improve profitability in this segment considerably in 2018 and further develop the acquisitions made in previous years. The numbers in our smallest segment, Compact Class, were in line with our expectations.

Investing heavily in sites in Germany and abroad

With more than 10,000 people, our team in Germany makes up around two-thirds of our total workforce. Germany offers us myriad advantages such as highly skilled workers and outstanding infrastructure. Krones remains committed to Germany as a business location and has underscored this commitment with a promise to secure employment and the future of our German sites until the end of the year 2022. We will invest around €200 million in our German sites over the next five years. For example, we intend to build the factory of the future, equipped with the very latest logistics and digitalisation solutions, at our headquarters in Neutraubling.

However, the fact is that Krones generates around 90% of revenue in markets abroad, around the globe. For this reason, Krones will continue to invest heavily in expanding its global footprint. Being as close to our customers as possible is of great strategic importance. That applies especially to aftersales service but also to production.

Because we have to expand value creation abroad in our core segment, we will establish a new plant in Hungary. The new production site is slated to go into operation in early 2019. We intend to employ 500 new people there. Krones will assemble components and modules at the site, which will be located in Debrecen, Hungary.

Changes to the executive management team

Rainulf Diepold, who served as Chief Sales Officer on Krones’ Executive Board since the year 2000, retired from the board at the end of 2017, having reached the age limit for membership stipulated under the company’s internal Executive Board rules. The entire Executive Board would like to thank Rainulf Diepold for his many years and extremely successful work at Krones. Thomas Ricker succeeds Rainulf Diepold as CSO. Ricker has been a member of the Executive Board, responsible for Bottling and Packaging Equipment, since 2012. He switched over to CSO on 1 January 2018.

Ambitious growth targets for 2018

Despite the many opportunities our market offers, conditions are unlikely to improve in the near future. Nevertheless, we have some pretty big plans for 2018. We aim to further increase Krones’ revenue and earnings. For 2018, we are forecasting revenue growth of 6%. We intend to maintain an EBT margin of 7.0% despite start-up costs for the plant in Hungary.

People are the foundation of Krones’ success

Highly qualified, motivated employees will be crucial to our ability to meet our short and medium-term goals. Getting new employees excited about working for Krones will be as important as continuing to train and educate our existing personnel. Krones success depends on our people. That is why, on behalf of the entire Executive Board, I would like to extend my sincere thanks to the entire Krones team for contributing their dedication and skill. As a team, we will ensure Krones’ continued success.

Christoph Klenk
CEO

Krones Group Annual Report 2017

Krones offers machinery and equipment for producing, filling, and packaging beverages and other liquid food. This market is growing at a relatively stable rate of around 4% to 5% each year, benefitting from megatrends such as steady population growth, rising standards of living in the emerging markets, and urbanisation. Another factor driving growth is the rapidly increasing number and variety of packaging forms and beverage types. Those factors and the trend towards the digitalisation of beverage plants are enabling market growth to outpace GDP growth for the long term.

We offer our customers everything they need from a single source, from beverage production to filling to packaging. Intralogistics solutions, digitalisation, and high-level after-sales service round out our portfolio. We offer products and services to cover everything from the simple to the highly sophisticated. That makes Krones one of the few one-stop shops in this market.

Besides our big European competitors, a number of smaller providers are also vying for orders. However, most of our competitors only offer products relating to a certain part of beverage production or operate only in certain regions. Krones’ global turnkey approach and global service network put the company in an excellent position and we intend to defend our strong position in our core segment and to considerably improve our standing in our two smaller segments.

Just as the market offers opportunities, it also presents a number of challenges for Krones. Political uncertainties, protectionism, and at times acute economic crises in individual countries and regions are now a daily reality. That means we have to be more flexible, faster, and more regional in our operations. The fact that our business is well balanced and diversified helped us to offset fluctuations in demand and meet our forecasts for revenue and earnings once again in 2017.

The fight for orders will remain intense as competitive pressures are not letting up. On the customers’ side of things, mergers and acquisitions are increasing buying power and sometimes delaying capital investments. However, increasing digitalisation and integration of production will forever change our market and its business models and require capital investment.

Medium-targets through 2020 – 7/8/22

To keep moving the company forward for the long term, the Krones team has set new medium-term targets. 7/8/22 stands for:

7% revenue growth per year on average

8% EBT margin

22% working capital to revenue ratio

Krones Group Annual Report 2017

Making use of growth opportunities

Krones intends to increase revenue by 7% each year on average through 2020. In order to achieve that, we will have to seize market opportunities in a purposeful manner. That is why Krones is focussing on markets that exhibit higher-than-average growth in beverage consumption, aiming to achieve higher-than-average revenue growth there. We are aiming for especially strong business development in Africa and Asia, where the overall population and the middle class are growing rapidly.

The proliferation of different products and packaging forms and the trend towards smaller packaging units are additional factors driving growth. More and more, customers are demanding extremely versatile machines and lines. Krones aims to claim a large piece of this burgeoning market segment by offering the best, most advanced technology. LineXpress is an excellent example. This Krones solution automates much of the product changeover process, thereby accelerating changeovers considerably. At drinktec, we presented for the first time our “Bottling on Demand” proof of concept study, production of the smallest possible batches down to just a single unit.

Mergers and acquisitions will also contribute to growth at Krones. Besides intralogistics and process technology, information technology is another area of interest for acquisitions. We are also focussing on further evolving our most recent acquisitions such as System Logistics in order to accelerate the generation of internal growth from them. Around 2% of annual revenue growth is expected to come from acquisitions through 2020.

Driving growth with existing product range and innovations

As a rule, all of our products and solutions must create added value for our customers. At drinktec, Krones presented innovations that demonstrated our commitment to putting customer benefit front and center in all new developments. Continued innovation in all areas remains the basis for sustainable growth at Krones. In this respect, we will not only strengthen the three main pillars of our business: beverage production, bottling and packaging, and intralogistics. After-sales service and IT and digitalisation solutions will also contribute to our targeted growth.

With the “House of Krones” concept, Krones has precisely tailored its business model to its customers’ needs and to the state-of-the-art beverage factory.

We intend to further grow our core segment, Bottling and Packaging Equipment. Because we have to expand value creation abroad in our core segment, we will establish a new plant in Hungary. Starting in 2019, this new location will employ around 500 people for the manufacture of machine components and modules. In this segment, we still see good potential for growth in less complex systems that deliver high and mid-range performance. Krones will step up efforts to develop simple, cost-optimised products and solutions. In addition, we will continue to grow our high-end operations with leading technologies and capitalise on customers’ steadily rising demands.

The Beverage Production/Process Technology segment covers all production processes upstream and downstream of filling and packaging. It includes beverage production and treatment as well as intralogistics. We will continue to work hard to achieve our medium-term growth and profitability targets in this segment. The measures implemented at the end of 2015 for this purpose are taking effect but not as extensively or as quickly as we had hoped. However, we still firmly believe that the key to this segment’s long-term success lies in expanding the regional structure and establishing international hubs. Such a network will enable us to respond quickly and cost-effectively to customers’ needs and thus strengthen customer loyalty. Acquisitions made in specific regions in the last two financial years, such as Transmarket and Javlyn in the USA, will help us build that international structure. Now, it is time to take it a step further and make use of these newly acquired, local employees’ knowledge of their markets.

Intralogistics is of great importance both to customers and to Krones, in its role as a one-stop shop. Short pathways, streamlined processes, and flexible material flows that can be easily adapted to production and delivery are of critical importance. We provide customised systems to handle any task. With Syskron GmbH, our group’s own specialist for highly sophisticated intralogistics projects, and System Logistics, in which we acquired a majority stake in 2016, we are in an excellent position to utilise the market’s high potential for growth. In the future, Krones intends to grow both its international reach and its product range in this area.

Digital beverage plant holds enormous potential

The digitalisation of beverage plants opens up enormous potential for growth for Krones in the medium and long terms. As a full-service supplier, the company is in a position to capture all material and data flows along a customer’s entire production process and to intelligently connect them. Technologies like cloud computing, big data, smart data, and the Internet of Things serve as a basis for new business models. We intend to leverage this potential along the customer’s entire value chain. Our goal is to create even more added value for our customers.

In order to successfully implement the concept of digitalisation in collaboration with our customers, Krones has structured it into five main points.

Integration

Digitalised supply chain

Collaboration

Analytics

Total productive management (TPM)

Digitalisation is not just a topic of the future for Krones. The company is already supporting customers with smart machines and customised IT solutions from two different portfolios – Krones software applications and SAP modules.

Krones will continue to invest heavily in digitalisation capacities and further grow its IT team. The agile organisation of our software incubator Syskron and our innovation lab will enable us to develop creative digital business models and quickly make them ready for market.

Profitability to increase further

With profitability having been consistently strong for some time, Krones now intends to take it to the next level. Expanding our global presence will be an important part of this process. We currently generate only a small share of value added outside Germany although nearly 90% of revenue comes from abroad. This imbalance is unhealthy and fraught with risk – and we intend to correct it. We have already taken an important step in this direction by establishing additional international subsidiaries and acquiring companies abroad. We will continue to pursue our localisation strategy and generate an increasing share of value creation in the regions. We will also establish some production capacities near our customers worldwide. That will enable us to reduce personnel and materials costs and deliver regionally adapted products to the emerging markets at competitive prices.

The next stage of modularising our products is aimed at countering the rising prices we pay for materials. On the one hand, we will further increase the degree of modularisation of our machines and lines and thus reduce their complexity. On the other, we will simplify the design of our modules. That will enable more suppliers in the regions to meet our specifications. That, in turn, will increase competition among suppliers and improve our purchasing prices.

In order to increase Krones’ profitability for the long term, we will also further expand our after-sales service business. Proximity to customers is crucial for Krones’ success in this business line. That is why we will further increase the number of service and sales offices. To make this work, we must recruit and retain enough sufficiently qualified people in the regions. We are investing heavily in training and continuing education for employees in the regions in order to reduce the relatively high rate of employee turnover in the emerging markets.

Reducing working capital – unlocking capital

Of our three core targets, the third is working capital to revenue. At 27.3%, we still have a ways to go to reach our 22% target. We have developed a number of short and medium-term measures to achieve our target and reduce working capital. These include cutting lead times, accelerating the process of commissioning lines at customers’ plants, and reducing inventories. Reducing the ratio of working capital to revenue in the years ahead will directly increase the capital available for investment.

Solid financial position enables us to invest in growth in Germany and abroad.

With net cash and equivalents of around €157 million and an equity ratio of 43.8%, Krones is in excellent financial health. Combined with operating profits, that gives the company enough money to invest in growth, acquire additional companies, and pay out dividends. Our dividend strategy is to pay out 25% to 30% of consolidated net income to shareholders.

To remain competitive for the long term, Krones must invest – in its German sites as well as in its international presence. In Germany, we will invest around €200 million in the years ahead. A large share of that money will go towards the factory of the future, in which we intend to digitalise our own internal processes and stages of production as far as possible – as at our customers’ plants – and thereby increase our own productivity and efficiency. Germany will remain the development and innovation headquarters for Krones machines and lines. But we will also invest substantially in resources abroad. Besides establishing and expanding our international service centres and engineering hubs, we will also invest in production facilities. In addition to the new factory in Hungary, mentioned previously, we are also growing our site in Taicang, China, substantially. There, we will manufacture machines specifically for the local market, particularly for bottling and packaging water. We will also expand our Franklin plant in the USA and produce labellers there using components made in Germany. It is important to us that these investments abroad not come at the expense of our core workforce in Germany but rather that we continue to maintain and create jobs in Germany as well.

Employees are the key to growth and long-term success

Every one of our employees is important for our company. Any strategy is only as good as the people implementing it. Our 15,300-strong team is moving Krones forward every day. They are essential to Krones’ long-term success. We will have to expand our team even further in order to handle the growth we are forecasting. Thus, it is important that Krones establish a reputation as an attractive employer – worldwide. Particularly at our sites abroad, we will step up these efforts and further expand the training centres in Africa, China, Southeast Asia, and South America as they enable us to build skills and expertise within our global value chain. This close proximity helps us to better understand our customers, market, trends, and developments and ultimately increases customer satisfaction. In Germany and Europe, workforce growth will be less dramatic. But, here too, we will continue to invest in our team and provide ongoing training and continuing education.

Christoph Klenk
CEO

Krones’ management system

Krones’ management primarily uses the following financial performance indicators to steer the group and its three segments:

Revenue

EBT margin (earnings before taxes in relation to revenue)

Ratio of working capital to revenue (at the group level)

In order to strengthen our market position and utilise economies of scale, we aim to achieve revenue growth above the market average.

Earnings before taxes (EBT) are an important earnings indicator. It is from EBT that the group pays out taxes and dividends and makes investments and capital expenditures.

Profitability, measured as the EBT margin, is among our key targets and parameters. It indicates the return on revenue (earnings before taxes in relation to revenue). For the group, we calculate the target margin as the weighted average of the three segments.

Another major performance indicator is working capital to revenue, which is calculated at the group level. Working capital is calculated as follows: (inventories + trade receivables + prepayments) – (trade payables + advances received). The result indicates how much capital is needed to finance the generation of revenue. The lower the number, the less capital is tied up in operations and, thus, the more financial leeway the company has to use its cash and cash and cash equivalents for something else.

In addition to these performance indicators, we also use the development of free cash flow (cash flow from operating activities less cash flow from investing activities) and Roce (return on capital employed, the ratio of EBIT to average
capital employed) as a guide.

Report on expected developments

Positive outlook for the global economy

Conditions for growth are favourable for Krones overall

Executive Board expects increases in revenue and earnings before taxes

World economy is projected to grow 3.9% in 2018

The International Monetary Fund (IMF) upgraded its forecasts for global economic growth in January 2018. The experts are projecting that the global economic upswing will continue to accelerate in 2018, driven primarily by the tax reform in the USA. The reform is expected to benefit not only the US but also international trading partners. The IMF expects the positive trend in Europe will also contribute considerably to the global economy. In all, the IMF is forecasting global economic growth of 3.9% for 2018 (2017: 3.7%).

The emerging market and developing economies will likely grow more than the global economy overall in 2018 due to the powerful uptrend in Asia. China will once again play a significant role here. The IMF expects the world’s second-largest economy to grow its GDP by 6.6% in 2018 (previous year: +6.8%). India’s economy is likely to expand at an even faster pace. The IMF is predicting that the country’s GDP will grow by 7.4% (previous year: +6.7%). The uptrend in the Middle East/Africa region is expected to pick up considerable speed in 2018. The IMF projects that the region’s GDP will grow by 3.6% (previous year: +2.5%). In all, the IMF is forecasting 4.9% economic growth for the emerging market and developing economies for 2018 (previous year: 4.7%).

Krones Group Annual Report 2017

The IMF’s confidence with respect to the economic outlook in the advanced economies has increased. The main reason is the tax reform in the USA. The world’s largest economy is expected to increase GDP by 2.7% in 2018 (previous year: 2.3%). In October 2017, before the tax reform passed, the IMF forecast was at just 2.3%. In January 2018, the IMF also raised its growth forecast for the euro area and for Germany in particular. The economists now expect the common currency area’s GDP to increase 2.2% (previous year: 2.4%). The previous forecast was for 1.9% GDP growth. Germany’s economy is projected to expand by 2.3% in 2018 (previous year: 2.5%). In autumn 2017, the forecast was for just 1.8% growth. For Japan, the IMF is forecasting 1.2% GDP growth in 2018 (previous year: 1.8%). In all, the IMF is forecasting 2.3% economic growth for the advanced economies for 2018 (previous year: 2.3%). That is 0.3 percentage points higher than the October 2017 forecast.

Consumer spending is a key factor determining the propensity of Krones’ customers to make capital expenditures and, consequently, the level of demand for beverage filling and packaging equipment. Low unemployment and inflation rates have a positive effect on consumer’s buying power and therefore support demand for packaged food and beverages. Thus, unemployment and inflation rates indirectly impact demand for Krones’ products and services. We do not expect either of these factors to have any negative effects on Krones’ business overall in 2018.

Positive outlook for Germany’s machinery sector

The strong global economic outlook is likely to have a positive impact on Germany’s machinery sector. For that reason, the German Engineering Federation (VDMA) is cautiously optimistic about 2018 and expects the sector to achieve further growth. The VDMA expects the value of machinery and equipment produced in 2018 to rise by 3% year-on-year.

The food and packaging machinery subsector, to which Krones belongs, is likely to grow more than the industry as a whole. The VDMA is projecting 4% revenue growth for this subsector for 2018.

Krones optimistic going into 2018

With economic forecasts for the current year positive overall, Krones is optimistic going into 2018 despite several political and economic uncertainties. The packaging machinery market is growing at a relatively stable pace because demand for packaged beverages and foods is rising. Despite the positive environment, our market remains challenging. Customers’ buying power is increasing as a result of mergers and acquisitions and the fight for orders remains intense. We expect no support from prices in 2018.

Revenue and earnings expected to increase further in 2018

Krones intends to take the momentum from a successful drinktec 2017 into the current year. Launching new products and services and further reducing costs remain important factors in our effort to grow further and increase earnings in all three segments in 2018. Moreover, Krones will increase its presence worldwide and move even closer to customers. Parts of procurement, engineering, and production will take place in the regions in which our customers operate their plants. That will enable us to deliver regionally-adapted products faster and at more competitive prices.

Beginning in 2018, our core segment Machines and Lines for Product Filling and Decoration will also include our machines and lines for the compact class, that is subsidiaries Kosme and Gernep. Innovations and the continued expansion of international service centres will contribute to the newly structured core segment’s growth in 2018. We intend to improve our position in the emerging markets by offering less-complex systems that deliver high performance. In addition, Krones will continue to press ahead with the modularisation of our products in our core segment and expand our global footprint. That will enable us to achieve better procurement terms and increase efficiency within the company.

Krones expects core-segment revenue to increase by 4% in 2018 on strong order intake and an attractive product range. Krones expects the reported EBT margin to be 8.3% in 2018 despite high capital expenditure.

We intend to significantly improve profitability in the Machines and Lines for Beverage Production/Process Technology segment in 2018. Measures implemented have not yet taken their full effect. However, we are confident that we will be able to leverage revenue and earnings potential this year by further expanding our global footprint and fully integrating the acquisitions in this segment.

Intralogistics, which is part of the Process Technology segment, is also expected to benefit from positive momentum coming out of the drinktec trade fair this year. We want to tap the market’s high potential for growth by further developing our subsidiaries System Logistics and Syskron, both regionally and in terms of product technology.

In all, we are forecasting 15% revenue growth and a reported EBT margin of 1.0% for the Process Technology segment for 2018.

Based on the current macroeconomic prospects and expected development of the markets relevant to Krones, we are targeting consolidated revenue growth of 6% in 2018. The regional distribution of revenue in 2018 is likely to be changed a little from the previous year.

Krones intends to keep profitability stable despite heavy investment in digitalisation and start-up costs associated with our global footprint, particularly the new site in Hungary. The company expects to post an EBT margin of 7.0% in 2018. We intend to improve our third financial performance target, working capital to revenue, to 26%.